The Investec Equity Fund1 invests in shares where future earnings expectations are being revised upwards (or are highly likely to be revised upwards) while trading at reasonable valuations. These positive revisions need to be sustainable, and preferably, operationally driven. In mid-2016 we started buying Barloworld and we currently have an overweight position in the stock.
Founded in 1902, Barloworld is one of South Africa’s oldest companies. In the early years, the company sold woollen goods, blankets and coats but over time expanded into many areas including motor retail, building materials, handling equipment, consumer electronics and steel manufacturing. The company has evolved over the years, selling non-core assets and repositioning itself as a distributor of leading global brands such as Caterpillar, Avis, Budget, Audi, BMW, Ford, Jaguar Land Rover, Mazda, Mercedes-Benz, Toyota, Volkswagen, Hyster and Massey Ferguson. Barloworld’s core divisions comprise Equipment (earthmoving and power systems), and Automotive and Logistics (car rental, motor retail, fleet services, used vehicles and disposal solutions, logistics management and supply chain optimisation).
While we have a substantial holding in Barloworld, the market remains fairly sceptical about the company’s prospects. So why do we like Barloworld?
Since 2012, precious and base metal prices have been on a downward trend. These sub-economic price levels put mining companies under significant pressure, resulting in global order books drying up as production slowed. A substantial portion of Barloworld’s revenue comes from the sale of Caterpillar equipment, which is extensively used in mining operations. Not surprisingly, the company has faced a low market rating due to a depressed order book.
We, however, did not expect the capital expenditure ‘strike’ that prevailed through the tail end of 2015 to mid-2016 to continue indefinitely. This was due to the aging profile of global equipment parts, the increasingly positive global GDP growth outlook and signs of a better commodity price environment. In the second half of 2016, green shoots were indeed evident in the form of better commodity prices that in turn breathed some life into the capital expenditure cycle.
Russia, which comprises approximately 25% of Barloworld’s equipment division’s profits, did not follow the global diversified miners by investing heavily at the top of the 2012 cycle. Consequently, the Russian miners have relatively better balance sheets and their equipment order books have surprised on the upside.
Furthermore, in the first half of 2016, Barloworld’s joint venture in the DRC with Katanga Mining (which contributed 15% to Barloworld’s group profits in 2015) faced low copper/cobalt prices and a mining stoppage. This caused the operations to be loss-making in 2016. These operations have now returned to profitability and are projected to cumulatively add an additional 10% to group profits this year and next.
Profit growth recovery from these two areas (Russia and the DRC) is expected to be very important to Barloworld’s growth cycle in the 2017 and 2018 financial years. In addition, it is important to note the increasing diversity in the geographical contributions to profit from the mining equipment business of Barloworld. The contribution from the sub-Saharan Africa ex-DRC (SSA) business is expected to decline to 57% in the 2018 financial year, versus a contribution of 84% in 2012. This trend is due to the expected steady and strong growth from Russia, but also the recovery in the DRC’s contributions.
Barloworld discloses its equipment order book every six months and Figure 1 highlights the order book bottoming in March 2016 – a drop of more than 80% since its peak in 2012.
Figure 1: Barloworld’s order book development
Source: Barloworld Limited, Investec Asset Management as at 31 March 2017.
In March 2017, the group's order book increased by R1.3 billion (US$100 million) from the September year-end and almost doubled year-on-year. We believe the order book should grow by a further R2 billion (US$150 million) when Barloworld reports its profits for the 2017 financial year (as at 30 September).
In our experience, the market underestimates the amount of profit leverage at these business inflexion points. Hence, it is common to see conservative profit estimates coming out of the cycle bottom or conversely, aggressive estimates beyond the cycle top. In our view, the market is underestimating the extent of Barloworld’s profit recovery in the 2018 financial year. We believe the market is not fairly pricing in its upside potential.
Yellow (Caterpillar) equipment represents more that 50% of Barlow’s operating profits. Parts and services enjoy a much higher profit margin than selling new equipment. Over its working life, revenues from parts and service are typically 4x-5x that of new equipment sold, and typically 10x that in margin terms. Therefore, if new equipment is sold at a 2% margin, the parts and services margin will be 20% over the equipment’s life cycle. Using this relationship, we estimate that for each additional rand in new equipment sold, Barloworld’s after-tax net present value cash flow rises by approximately 25 cents.
With the order book now recovering, future earnings should begin to show better growth and this trend in growth expections is illustrated in Figure 2. Earnings per share (EPS) growth for the 2018 financial year, as measured by Bloomberg consensus estimates, has progressively been increasing since early 2016. The rise in growth expectations prompted us to take a look at Barloworld more closely. It peaked at 22% in April 2017 and recently was at 18% – tempered largely by the rand strengthening (the equipment is sold in US dollars).
Figure 2: Projected EPS growth for the 2018 financial year
Bloomberg consensus estimates as at September 2017, calculated as FY2 EPS - FY1 EPS smoothed with 30-day moving average.
Besides better EPS growth prospects, we also saw Barloworld’s low market rating relative to Caterpillar as a buying opportunity. We closely monitor the share price performance and price earnings ratio (PE) of JSE-listed Barloworld relative to Caterpillar, which is listed on the New York Stock Exchange. Barloworld’s share price performance and valuation have typically been highly correlated to Caterpillar. Barloworld’s relative PE rating to Caterpillar was close to its lows when we initiated our position in mid-2016. This signified a buying opportunity to us.
Barloworld’s Automotive and Logistics division has been under pressure, largely due to weak demand amid poor economic conditions and no interest rate relief for five years. The South African Reserve Bank (SARB) cut interest rates for the first time in five years by 25 basis points in July of this year. While we believe this could be a fairly mild cycle in terms of expected interest rate cuts, it should provide some support to improved trends in consumer disposable income, which in turn is expected to lead to better new vehicle sales. We believe this should provide some underpin to Barloworld’s largely South African, Automotive and Logistics division.
From a low base in 2016, passenger car sales are beginning to recover with green shoots evident in the monthly trading data in July and August 2017. In our view, the expected 5% decline in new vehicle sales by market participants is too conservative. Provided these positive sales trends persist, we would expect to see better earnings prospects for Barloworld’s vehicle division. Furthermore, car rentals have shown solid operating profit growth and the group continues to extract value from the Avis and Budget dual brand strategy.
Barloworld has a new leadership team in place and the immediate focus is to address the challenge of underperforming assets that are destroying value and supressing returns. Some 20% of group assets are affected, namely Iberian equipment and Logistics. To this end, we expect the loss-making Iberian equipment businesses to be sold in the near term, with new equipment territories being contemplated for entry. Logistics is expected to see a restructuring that should begin to drive profits and returns within 12 months.
Investors became overly negative about the prospects for global mining equipment spend as well as domestic car rentals and vehicle sales. Barloworld’s market rating reflected this bearish sentiment. However, higher commodity prices, a recovery in mining equipment orders from especially Russia and an improvement in the group’s DRC operations should drive the profit growth recovery in the 2017 and 2018 financial years. A declining interest rate cycle should also provide some underpin to new vehicle sales, another important contributor to profits.
In mid-2016, we saw the potential for the market to upgrade EPS projections and we initiated our position. The market has been steadily increasing its earnings growth estimates. As the green shoots of recovery gain a foothold, we expect earnings expectations to be revised further upwards. We are confident that the new leadership team’s restucturing efforts will help to create more value for shareholders.
1The total expense ratio of the Investec Equity Fund is 1.99%.
All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long-term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing, up to 10% of fund net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the Manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). Issued by Investec Asset Management, October 2017.